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CD vs Savings Account: What Are They & Which Is Best for You?
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When securing your financial future, choosing the right savings vehicle is essential. Two of the most common options are Certificates of Deposit (CDs) and savings accounts. But what exactly are they, how do they differ, and which one best fits your financial goals? This comprehensive guide dives into the CD vs savings account debate to help you make an informed decision.
LESSON CONTENTS
Understanding the basics: What is a CD vs. a savings account?
Before comparing the two, it's crucial to understand what each account entails.
Savings account
A savings account is a deposit account at a financial institution like a bank or credit union. It lets you deposit money, earn interest, and withdraw funds relatively easily. These accounts are the best for money you might need in the short term, such as an emergency or a vacation.
Key features of savings accounts include:
- Liquidity: High liquidity means you can access your funds anytime without significant penalties.
- Interest rates: Typically offer lower interest rates compared to other savings vehicles.
- Safety: Insured up to $250,000 per depositor, per institution, providing peace of mind for your deposits. If opened at a credit union, the National Credit Union Administration (NCUA) provides this protection. If opened at a bank, the Federal Deposit Insurance Corporation (FDIC) ensures your funds are similarly covered.
Certificates of Deposit (CD)
A Certificate of Deposit is a time-bound deposit account that requires you to leave your money untouched for a specific term, ranging from a few months to several years. Banks usually offer higher interest rates than savings accounts in exchange for this commitment.
Key features of CDs include:
- Fixed term: Money is locked in for a predetermined duration.
- Higher interest rates: Offer higher, fixed interest rates than savings.
- Early withdrawal penalties: Withdrawing funds before maturity often results in penalties ranging from 90 days to 365 days’ worth of interest (Bennett, 2024).
- Insured: Also insured up to $250,000 per depositor, per institution, providing peace of mind for your deposits. If opened at a credit union, the NCUA provides this protection. If opened at a bank, the FDIC ensures your funds are similarly covered.
How do interest rates differ between CDs and savings accounts?
Since both instruments are ways to accumulate savings, their interest rates matter. In most cases, they are a pivotal factor when choosing between a CD vs savings account. Here is how they compare:
Savings account interest rates
- Variable rates: Savings account interest rates are usually variable, meaning they can change based on economic conditions and the Federal Reserve's policies.
- Lower than CDs: Typically, rates are lower compared to CD rates. As of March 2024, the average national interest rate for savings accounts at credit unions was 0.20% compared to
- Compounding interest: Interest is typically compounded daily or monthly, allowing your earnings to grow over time.
CD interest rates
- Fixed rates: CDs offer fixed interest rates, guaranteeing the same rate throughout the term of the CD.
- Higher returns: Because you're committing your money for a set period, banks reward you with higher interest rates, as highlighted above.
- Longer terms, higher rates: Generally, the longer the term of the CD, the higher the interest rate. However, CD rates are influenced by economic factors. For instance, when inflation is high—such as now—the Federal Reserve maintains a higher federal funds rate. As a result, during inflationary periods, short-term CD rates are usually higher than long-term rates.
Which option offers better flexibility: CDs or savings accounts?
Your savings cater to emergencies or serve long-term goals like a house deposit or a kid's college tuition. Therefore, depending on your needs, flexibility is crucial when evaluating savings vs CDs.
Savings accounts are more flexible since you can withdraw funds at any time without penalties. However, some banks limit certain types of withdrawals to six per month due to federal Regulation D requirements (Federal Reserve, 2024). Although the Fed lifted this transaction limit in April 2020 due to the pandemic, some banks still enforce it. Overall, easy access makes savings accounts suitable for unexpected or emergency expenses.
In contrast, CDs offer little wiggle room in terms of access. CD terms dictate that funds are locked in for the duration of the CD. Thus, withdrawing funds before the maturity date often incurs penalties, such as forfeiting several months' worth of interest. Still, you can use a CD laddering strategy to balance flexibility and higher interest rates.
The decision between a CD account vs savings account largely depends on your financial goals, risk tolerance, and time horizon.
A CD is ideal for or when:
- Long-term goals: You're saving for a long-term goal, such as buying a house or funding education.
- Higher interest rates: You want to take advantage of higher interest rates to maximize returns.
- Certainty of returns: You prefer knowing exactly how much interest you'll earn over a specific period.
- No immediate need for funds: You're confident you won't need the money until the CD matures.
A savings account is ideal for or when:
- Emergency funds: You're building or maintaining an emergency fund.
- Building savings: Unlike CDs that often require minimum deposits of at least $500, savings accounts support smaller deposits. Thus, savings are better suited for individuals looking to build their savings gradually with smaller deposits.
- Short-term goals: You're saving for short-term objectives like vacations or minor home renovations.
- Flexibility: You need the ability to deposit or withdraw funds at any time.
- Rising rate environment: When interest rates are rising, a savings account allows you to benefit from rate increases, whereas a CD locks you into a fixed rate.
Making the best choice for your financial goals: CD vs savings account
With an understanding of what a CD account vs savings account is, you can now make a choice. Determining the best for your situation involves assessing several factors.
Consider your time horizon
If you might need access to your money within a year, a credit union savings account is generally more appropriate. A CD is the appropriate savings vehicle for goals several years away and will offer better returns.
Assess the interest rate environment
If interest rates are expected to rise, locking in a long-term CD might cause you to miss out on higher rates later. On the other hand, securing a fixed rate with a CD could be advantageous in a stable or falling rate environment.
Evaluate your financial goals
Both CDs and savings accounts are low risk. However, despite higher returns, CDs require a lock-in commitment that might not suit everyone. You can split your funds between a CD and a savings account to balance flexibility and returns. Use this savings goal calculator to help evaluate your options.
Financial strategies
Your savings vs CD choice may come down to your preferred financial strategy. For instance, CD laddering – opening multiple CDs with staggered maturity dates – can enhance liquidity while earning higher interest rates. Some online banks offer savings accounts with rates competitive with shorter-term CDs. This way, you earn a good interest rate without sacrificing access to your funds.
FAQs
What are the key differences between a CD and a savings account?
The main differences lie in interest rates, accessibility, and terms. CDs offer higher, fixed interest rates but require you to lock in your funds for a set period, incurring penalties for early withdrawal. Savings accounts offer lower, variable interest rates but provide greater flexibility for deposits and withdrawals.
How do interest rates compare between CDs and savings accounts?
CDs generally provide higher fixed interest rates than savings accounts due to the commitment to leave funds untouched for a specific term. Savings account rates are variable and tend to be lower.
Can I access my money early with a CD, or should I use a savings account?
Accessing money from a CD before it matures usually incurs penalties. CD early withdrawal penalties mean savings accounts are a better choice if you anticipate needing your funds. Some banks offer no-penalty CDs or allow a one-time withdrawal, but these often come with lower credit union interest rates.
When is it better to open a CD rather than a savings account?
Consider opening a CD when you have funds you won't need in the near future and want to earn a higher, fixed interest rate. Also, if rates are high and you expect them to fall going forward, a CD is ideal to lock in higher rates.
What factors should I consider when choosing between a CD and a savings account?
Consider your:
- Liquidity needs: Savings are accessible, while CDs incur early withdrawal penalties
- Time horizon of your financial goals: CDs work well when saving for long-term financial targets like college education, while savings fit short-term financial goals.
- Current and projected interest rate environment: Savings accounts are variable and likely to be rewarding in a rising rate environment. In contrast, if rates are high and the forward trajectory is negative, a long-term CD locks in higher rates, providing higher returns.
- Certainty of returns: Fixed rates in CDs guarantee a predetermined interest amount, while variable interest rates in savings present uncertainty.
Citations
America’s Credit Union (2024, September 26). National Membership Benefits Report Mid-Year 2024. https://americascus.widen.net/s/kg7q9v5b8b/national-memberbenefits
Karen Bennett (2024, April 29). Here’s when an early withdrawal from a CD is worth it. Bankrate. https://www.bankrate.com/banking/cds/cd-early-withdrawal-can-come-at-a-high-price/
The Federal Reserve (2024). Regulation D1 Reserve Requirements. https://www.federalreserve.gov/boarddocs/supmanual/cch/int_depos.pdf
*PLEASE NOTE: This article is intended to be used for informational purposes and should not be considered financial advice. Consult a financial advisor, accountant or other financial professional to learn more about what strategies are appropriate for your situation.
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